The influence of litigation risk and internal audit source on reliance decisions

External auditor reliance on the work of internal auditors in an integrated audit of the financial statements and internal control is an important audit planning procedure that can impact audit efficiency and effectiveness. The purpose of this study is to examine how perceived auditor litigation risk and internal audit source affect external auditors' reliance decisions in an integrated audit environment under varying levels of risk of material misstatement. In an experimental study using 89 practicing Big 4 auditors, this study finds that auditors who perceive low litigation risk from placing reliance on the work of internal auditors will rely more on outsourced internal auditors than in-house internal auditors. The results also show that auditors' reliance decisions are sensitive to the level of account risk consistent with the risk-based approach to the integrated audit encouraged by the PCAOB.     

The use of analytical procedures by external auditors in Canada

The Enron debacle and other scandals highlight the issue of whether analytical procedures (APs) or more traditional audit approaches based on substantive testing are more appropriate. This paper surveys the use of APs by Canadian external auditors and augments understanding of the impact of auditing standards on professional practice. Our results demonstrate that APs are extensively applied in practice, particularly by larger firms, and that their use dominates the final review stage of the audit regardless of firm size. While standards do not appear to be an important influence upon practice for audit firms in general, this is not the case for smaller firms. Though auditors place more reliance on APs to reduce tests of detail, there are limits to this reliance. Our results indicate that while auditors may have increased their use of APs with the expectation of efficiency gains, these may be realized at present only partially.     

External auditors' willingness to rely on the work of internal auditors: The influence of work style and barriers to cooperation

The extent to which external auditors rely on the work of internal auditors is an important judgment. Recently, the Public Company Accounting Oversight Board has recommended that external auditors “rely (more) on the work of others” to reduce the greater-than-expected costs associated with compliance with Section 404 of the Sarbanes–Oxley Act. Reliance decisions, however, are complex decision tasks that require professional judgment and may be influenced by a number of factors, both external (environmental) and internal (cognitive and affective), including the auditors' working style and pervious experiences related to barriers to external/internal auditor cooperation (e.g., previously experienced low versus high internal auditor objectivity and/or competence). We experimentally examine these influences in our research reported herein. Consistent with expectations, external auditors' work styles significantly influenced the extent of planned audit testing, internal auditor reliance judgments, and interpretation of analytical procedures results. Auditors' perceptions about internal auditors' competence and objectivity, developed over years of interaction, also influenced these judgments, and interacted with work styles. Inconsistent with expectations, auditor rank (senior versus manager) did not influence judgments.     

Auditor liability: A comparison of judge and juror verdicts

This research examines differences between judges and jurors in rendering liability judgments in auditor litigation cases. While any number of case contexts would allow us to contrast and compare judges and jurors, we chose one that we believed would also address a second timely issue, auditor reliance or non-reliance upon the work of others. Within the general context of litigation of an alleged audit failure, we manipulated, between-participants, external auditor reliance on the work of others (relied on outsourced work, relied on in-house internal auditors’ work or did not rely). Our results show differences in the liability assessments of judges and jurors. Judges assign more liability to auditors that rely on the work of in-house internal auditors, less liability to auditors that rely on outsourced internal auditors and the least liability to auditors that choose not to rely on the work of internal auditors (but re-perform the work themselves) while jurors assess higher liability regardless of the work done by the auditors. Mediation analyses suggests the differences found in the overall liability assessments of jurors and judges are partially driven by their divergent attitudes towards the public accounting profession with jurors’ unfavorable attitudes leading to them assign liability regardless of the work performed. Further analysis suggests juror insensitivity to our reliance manipulations may reflect a strict liability perspective (consistent with prior work by Charron and Lowe (2008)); while judges consider other factors when making liability assessments.     

An Empirical Investigation of the Interface Between Internal and External Auditors

Professional standards place specific responsibilities on auditors for the discovery of material mis-statements in reports of corporate financial performance. Certain factors have been shown to increase the likelihood of fraudulent financial reporting. One warning sign is the potentially pervasive effect of a weak internal control environment consistent with a weak internal audit group. This study investigates the impact of internal audit department quality differences on auditors ‘willingness to place reliance on the work performed by internal auditors. The study also gives consideration to auditors’ recent experiences with material errors and irregularities and examines the influence of two previously untested individual auditor differences on audit judgment decisions: (1) conflict management style and (2) perception of internal/external auditor communication barriers. The results indicate that auditors attend to internal audit department quality differences and that individual auditor differences exhibit significant influence over auditor judgments. Implications for audit practice are considered and directions for future research are suggested.     

External auditors' evaluation of the internal audit function: An empirical investigation

Evaluation of the strength of the client's internal audit function by the external auditor (EA) has taken on increased significance due to stronger regulation around the evaluation of internal controls after SOX (2002). However, research examining how this evaluation occurs in practice is mixed and inconclusive. In this study, we examine empirically whether the Desai et al. (2010) theoretical model is reflective of how auditors make judgments about the strength of their client's internal audit function in practice. Specifically, we present external auditors with evidence about internal auditor work performance, competence and objectivity in a manner consistent with the structure of evidence evaluation implied by the Desai et al. (2010) model. We then compare the auditors' actual strength judgments to the strength levels predicted by the model and evaluate similarities and differences. Results indicate that no one factor dominates the strength judgment in all cases. In addition, EAs do not weigh negative evidence as heavily as does the model. When the evidence about the three factors is conflicting, external auditors have difficulty incorporating them in a consistent way into the calculation of their overall strength judgment. Finally, we find results consistent with prior research indicating auditors tend to be more sensitive to negative than positive evidence. Also, it is harder to move auditors' beliefs away from a negative position with positive evidence than to move those beliefs away from a positive position with negative evidence. Results suggest that additional training and use of a decision aid structured according to the Desai et al. (2010) model would be especially useful when evidence about internal auditors' work performance, competence and objectivity is conflicting.     

The Impact of Consulting Services on Audit Quality: An Experimental Approach

We use experimental markets to examine whether providing consulting services to a non‐audit client impacts audit quality. Our paper directly addresses concerns raised by the Public Company Accounting Oversight Board that the largest public accounting firms’ growth in their consulting practices threatens audit quality. We conduct an experiment proposed using a registration‐based editorial process. We compare a baseline where the auditor does not provide consulting services to conditions where auditors provide consulting to audit clients or where auditors only provide consulting services to non‐audit clients. Our unique design provides evidence on whether providing consulting to non‐audit clients strengthens the salience of a client‐cooperative social norm that reduces audit quality. We do not find differences in audit quality by condition in our planned analysis, however we find greater variation in audit quality in the conditions where auditors provide consulting services compared to the baseline. In unplanned analyses, our results suggest providing consulting services increases auditor cooperation with managers, increasing audit quality when managers prefer high audit quality and decreasing audit quality when managers prefer low audit quality.     

Evaluating the Work of Internal Audit: A Comparison of Standards and Empirical Evidence

Numerous changes have recently been proposed or made to audit standards providing guidance for external auditors' evaluations of internal audit work. This paper reports the results of a study to compare the UK's Accounting Practices Board Statement of Auditing Standard 500, first, with similar standards promulgated by international, Canadian and US societies, and second, with audit quality factors derived from practising internal auditors. The data for the latter comparison was obtained from a two-phase study that first generated a set of potential quality factors through intensive structured interviews with audit groups from six different and diverse organisations, and then obtained evaluations of these factors from a large sample of internal auditors worldwide. Results first indicate that there are strong similarities between the guidance provided by SAS 500 and that proposed or promulgated by the UK, international, Canadian and US audit groups. Furthermore, the guidance provided by these SASs for items to consider in evaluating the quality of internal audit work are largely in agreement with the factors determined by practising internal auditors. There are, however, several items listed in SAS 500 that are not considered useful by internal auditors and there are other factors considered crucial by internal auditors but not mentioned in the SASs.     

A study of whistleblowing among trainee auditors

Over the last number of years whistleblowers have been gaining prominence. This paper investigates some of the factors that influence the propensity or willingness to blow the whistle among trainee auditors. Three categories of factors are examined: audit firm organisational structures, personal characteristics of whistleblowers and situational variables.A survey of 240 final year students of the Institute of Chartered Accountants in Ireland was undertaken. Trainee auditors (just about to sit their finals) were asked about their confidence in internal and external reporting structures in their firms. Using four scenarios, audit trainees were questioned on their willingness to challenge an audit partner's inappropriate response to concerns raised during the audit. Finally, audit trainees were asked about the influence of legal protection on their likelihood of whistleblowing.Results indicate that where firms have adequate formal structures for reporting wrongdoing, trainee auditors are more likely to report wrongdoing and have greater confidence that this will not adversely affect their careers. Training increases this confidence. Trainee auditors also express a willingness to challenge an audit partner's unsatisfactory response to wrongdoing. Significant differences were found in attitudes depending on whether the reports of wrongdoing were internal or external. The willingness to report wrongdoing externally reduces for older (aged over 25) trainees.     

The potential impact of COSO internal control integrated framework revision on internal audit structured SOX work programs

The purpose of this research is to report the extent internal auditors employ structured work programs in SOX compliance programs and the extent external auditors are involved in development of internal audit work programs. Given the link between the internal audit framework established by the Committee of Sponsoring Organizations of the Treadway Commission and the development of SOX work papers, we also summarize and explain the May 2013 changes to the COSO Internal Audit Integrated Framework. We further posit the potential effects of these changes on extant structured SOX work papers.     

The Effects of Anticipation and Frequency of Errors on Auditors' Selection of Substantive Procedures

The process of audit planning continues throughout an audit engagement. Preliminary audit plans are developed in the early phases of an engagement, and are revised in light of information received in subsequent phases, such as the results of substantive tests. This study examines the effects of (1) auditors' anticipation of finding a particular error-type in substantive tests and (2) the frequency of occurrence of the error-type on auditors' revision of preliminary audit plans. An experiment was conducted with practising auditors as subjects. Three error-types were manipulated as part of eighteen sets of exceptions from accounts receivable confirmations that each auditor reviewed. We found that auditors who do not anticipate finding an error-type in substantive tests are more likely to increase the amount of planned audit work. No effect of frequency of an error-type within a sample was found.     

EXTERNAL AUDITOR EVALUATION OF THE INTERNAL AUDIT FUNCTION

This study examines the relative importance of the factors used by external auditors when valuating an internal audit function. The study also examines the consistency of external auditors in making evaluations of an internal audit function. The factors used are based on Statement of Auditing Practice AUP 2 “Using the Work of an Internal Auditor” and a similar study conducted in the U.S.A. The two factors which this study finds to be the most significant are ‘technical competence’ and ‘due professional care’. The study finds a high degree of consensus across the respondents with respect to the evaluation of the internal audit function, and a high degree of insight and stability in their judgements.     

Internal audit reporting lines,fraud risk decomposition,and assessments of fraud risk

The main purpose of this research is to examine the effects of internal audit reporting lines on fraud risk assessments made by internal auditors when the level of fraud risk varies. Significant emphasis has been placed on the importance of reporting lines in maintaining the autonomy of internal auditors, but the perceived benefits of requiring internal audit to report directly to the audit committee have not been validated or systematically investigated. Results of an experiment involving 172 experienced internal auditors and additional survey findings indicate that internal auditors perceive more personal threats when they report high levels of risk directly to the audit committee, relative to management. Perceived threats lead internal auditors to reduce assessed levels of fraud risk when reporting to the audit committee relative to when reporting to management. This finding runs counter to the anticipated benefits of requirements that the internal audit function report directly to the audit committee, and it reveals potential conflicts of interest and independence threats created by the audit committee itself. We also investigate the effects of fraud risk decomposition on risk assessments made by internal auditors. We find that fraud risk assessment decomposition does not have the same effects on internal auditors as it has on external auditors, and the effects of decomposition do not align with the expected benefits of decomposition.     

The Contribution of Internal Audit as a Determinant of External Audit Fees and Factors Influencing This Contribution

Despite extensive research on the determinants of external audit fees, there is little empirical evidence on the effect of internal audit contribution on the external audit fee. Using a cross-sectional regression model based on prior audit fee research, this study provides evidence that internal audit contribution is a significant determinant of the external audit fee. Further, a second model that provides evidence on the determinants of internal audit contribution is developed and tested. This second model indicates that internal audit contribution is influenced by internal audit quality and, conditional on the level of inherent risk, the availability of internal audit and the extent of coordination between internal and external auditors. These results are based on a unique data-set comprised of publicly available data matched with survey responses from internal and external auditors affiliated with 70 non-financial services Fortune 1000 firms. The sample includes all of the former "Big 6" international accounting firms and clients from twenty-nine different industries.     

The business risk audit: Origins, obstacles and opportunities

Is the business risk audit a better way to assess risks leading to focused audit testing, or is it simply a tool for generating opportunities to sell nonaudit services? Many feel strongly that the latter is more representative of the manner in which business risk audits were implemented. In this paper, I argue that the development of the business risk audit methodology in the 1990s was a complex process that arose naturally from the need to compensate for the commoditization of audits that occurred in the 1980s. The contemporaneous growth of risk management theories and processes provided a powerful perspective on which to base the re-engineering of the audit. However, the process of developing and implementing business risk audits was extremely difficult and may have run up against a number of unforeseen and unmanaged obstacles, particularly in regards to the existing rituals of the traditional audit. Given that the sales culture of consulting was taking hold among auditors at about the same time, it is possible that the well-intentioned efforts to revitalize the audit process were derailed by these difficulties and then diverted to support revenue growth via nonaudit services. When Enron and ensuing scandals occurred, questions arose as to whether the business risk audit was effective, or even appropriate. Regulatory initiatives that followed from the aftermath of Enron, such as an increased focus on management incentives for fraudulent reporting and greater in-depth analysis of internal controls, may provide a viable foundation for reconsidering business risk methods and melding the best of traditional substantive audits with the best of business risk auditing.     

Auditors' Efficiency Motivated Evaluation

This paper proposes an evaluation approach - “Efficiency Motivated Evaluation” (EME hereafter) - that auditors use in response to increased efficiency demands. EME is defined as discounting (emphasizing) negative (positive) audit evidence and making favorable assessments as the demands for efficiency increase. We propose that increased time pressure will exacerbate auditors' use of EME but that experience will mitigate this tendency. We conduct an experiment in which 83 auditors differing in experience evaluated internal control effectiveness under high or low time budget pressure. Consistent with expectations based on EME, auditors assess overall internal control effectiveness higher, and positive information about controls as more relevant, under high (compared to) low time budget pressure. Moreover, we find that less (compared to more) experienced auditors under high time budget pressure rate negative information about controls as less relevant. The results suggest the importance of assigning experienced staff to high time budget pressure engagements.     

The influence of judges' attitudes on liability assessments related to failed audits exhibiting significant audit team over-time or significant use of off-shore auditors

This study provides evidence on how audit firms' decisions to use offshore (outsourced) auditors or to assign on-site (local) auditors extensive overtime affect judges' evaluation of auditor legal liability I conduct a behavioral experiment in which actual judges responded to a hypothetical audit lawsuit. The results suggest auditors may be penalized during the litigation process depending on the extent of overtime or off-shoring and judges' attitude toward the public accounting profession. Judges with a positive attitude toward public accounting assessed more liability for an audit firm that used offshore (outsourced) auditors than for the use of extensive overtime for on-site auditors or a control condition. However, judges with a negative attitude toward the auditing profession assessed higher liability for auditors except when on-site auditors bore significant overtime in the final weeks of the audit.     

Why Press Coverage of a Client Influences the Audit Opinion

In this study I use an experiment to examine why auditors are more likely to issue going–concern opinions when the client has been the subject of negative press coverage prior to the date of the audit opinion. I find no evidence that negative press coverage increases auditors' perceptions of legal liability, as was suggested in the prior literature. I do find, however, that negative press coverage increases auditors' perception of a client's bankruptcy probability and this, in turn, leads auditors to modify the audit opinion. Because the press coverage presented in this study provides no new information, the results suggest that auditors react too strongly to redundant information. This over–reaction can result in inefficient allocation of audit resources and can have deleterious affects on clients. Accordingly, policy makers, auditors and their clients might be interested in how auditors' reliance on redundant information can be reduced.     

The Association between External Monitoring and Earnings Management in the Property-Casualty Insurance Industry

This paper examines the association between external monitoring and earnings management by property-casualty insurers. We extend previous work by Petroni and Beasley (1996) by expanding the set of external monitors to include both auditors and actuaries. We investigate whether certain auditor-actuary pairs are associated with less understatement of the loss reserve account by financially struggling insurers. Our data consist of loss adjustments reported by 465 property-casualty insurers for reserves established in 1993. The results indicate that under-reserving by weak insurers is essentially eliminated when the firm uses auditors and actuaries that are both from Big Six accounting firms. In contrast, non-Big Six actuaries have less impact on under-reserving by weak insurers. Our results suggest that the quality usually associated with Big Six auditors falls when the audit firm relies on third party actuaries to evaluate the loss reserve estimates of struggling insurance clients. We conjecture that Big Six actuaries insist on more conservative loss reserve levels because, compared to actuarial consulting firms, they are more attuned to the liability exposure of the auditor.